Certain payments received because of sickness, injury, or death are excluded from income when they meet statutory requirements. The exclusions below frequently appear on the EA exam.
Workers’ Compensation
Workers’ compensation is fully excluded when:
- Paid under a workers’ compensation act or similar statute
- Paid for occupational sickness or injury
- Paid to the worker or the worker’s survivors
Not Excluded
- Retirement benefits based on age, service, or contributions, even if the retirement resulted from an injury
- Wages received after returning to work (e.g., light‑duty pay)
Compensation for Sickness or Injury
The following amounts are excluded from income:
Compensatory damages
Excluded when received for:
- Physical injury
- Physical sickness
Paid as a lump sum or installments.
Emotional Distress
- Emotional distress caused by physical injury is excludable
- Emotional distress not tied to physical injury is taxable
- Physical symptoms of emotional distress (e.g., headaches, insomnia) do not convert it into a physical injury
- Medical expenses for emotional distress are taxable if previously deducted
Accident or health insurance benefits
Excluded when:
- The taxpayer paid the premiums, or
- The employer paid the premiums and they were included in the taxpayer’s income
No‑fault auto insurance disability benefits
Excluded when paid for loss of income due to injury.
Permanent loss or disfigurement
Excluded when paid for:
- Loss of a body part
- Loss of use of a body function
- Permanent disfigurement
These benefits must be based solely on the injury, not on time away from work.
Medical reimbursements
Generally excluded, but may reduce the medical expense deduction.
Life Insurance Proceeds
Life insurance proceeds paid due to the insured’s death are excluded unless the policy was sold (viatical or life settlement).
Lump‑Sum Payments
Excluded unless the amount exceeds the policy’s death benefit.
Installment Payments
Each installment includes:
- Excluded portion = death benefit ÷ number of installments
- Taxable portion = interest above the excluded amount
Special Rule for Pre‑1986 Spousal Deaths
If the insured spouse died before October 23, 1986, up to $1,000 per year of interest in installment payments may be excluded.
Endowment Contracts
An endowment contract pays a lump sum at maturity.
- Proceeds are taxable only to the extent they exceed the cost of the contract
- Cost = premiums paid − amounts previously received tax‑free
Accelerated Death Benefits
Accelerated death benefits paid before death are excluded when:
Terminal illness
Fully excluded if a physician certifies the insured is expected to die within 24 months.
Chronic illness
Excluded when:
- Paid for qualified long‑term care services, or
- Paid on a per‑diem basis up to statutory limits
Viatical Settlements
A viatical settlement is the sale of a life insurance policy to a licensed viatical settlement provider.
Excluded when:
- The insured is terminally or chronically ill
- The provider is properly licensed
- Payments meet statutory requirements